This blog is about struggles for the control of corporations. For the most part, I'll focus on public corporations headquartered in the United States, issuing securities according to the rules stipulated by the SEC in Washington and (typically) governing their affairs by the laws and judicial decisions of the state of Delaware.
My own prejudices are ... well, I think I'll let you work them out as we proceed day to day.

Monday, August 3, 2009

BS v. BS: An update

Last December, the Financial Times ran an opinion column by Nassim Nicholas Taleb, author of Fooled by Randomness (2001) and The Black Swan (2007) with co-author Pablo Triana. They used the ongoing market chaos to reinforce an argument they had made before, that contemporary financial risk management in general is misguided and that the Black Scholes Merton model is part of the reason. I cannot help but think of this as the "Black Scholes versus Black Swans," or the BS v. BS controversy.

"Ask for the Nobel prize in economics to be withdrawn from the authors of these theories," they urged their readers. "Boycott professional associations that give certificates in financial analysis that promoted these methods. The fraud can be displaced only by shaming people, by boycotting the orthodox financial economics establishment and the institutions that allowed this to happen."

In May of this year, GQ ran a flattering article on Taleb called "The Thinker," in which the writer, Will Self, describes Taleb as "a genuinely significant philosopher ... someone who is able to change the way we view the struicture of the world through the strength, originality, and veracity of his ideas alone."

Taleb claims, naturally, to do a good deal more than theorize about finance -- he claims to have proven his own views in practice. In this regard, I note that the above passage in Self's essay appears soon after a quotation with a startling number in it, a number ($20 billion) that has attracted a lor of attention since the appearance of this issue of GQ, and has in fact become a new battleground in the war of BS v. BS.

"We didn't short the banks -- there's not much to be gained there, there were all these complex instruments, options and so forth. We'd been building out positions for a long while ... when they went to the wall we made $20 billion for our clients, half a billion for the Black Swan fund." So Taleb supposedly told Self.

So presumably, in addition to the profit he made for and through his own fund, he made another $19.5 billion for outside clients. Janet Tavakoli picked up on this right away, and she contacted Nassim about that $20 billion figure. He told her that the magazine made an error there. Did they just make the number up? Perhaps not. The $20 billion, Taleb said, "might correspond to the face value of positions."

The mistake is not a trivial one. It relates to the whole issue of the "scalability" of results. It is one thing to claim you've made some money picking up pennies in front of a steam roller because you've been nimble enough to dart in and out safely. It is another thing to say that the strategy can be increased indefinitely to any scale -- to even a $20 billion scale -- that there is that much money in front of aforesaid steamroller.

Last week, Tavakoli -- the principal of Tavakoli Structured Finance -- revisited the matter of the disappearing $20 billion on her website, in a piece called "Where Were the Drama Pundits [Whitney, Taleb, and Gasparino] When It Mattered?"

She notes that Taleb has posted the GQ article, with its $20 billion figure, on his website, www.fooledbyrandomness.com, and he is silent there about the error. Indeed, Taleb praises Self's profile of him as one of the "most representative overall" yet done.

Silence on a little matter of $20 billion may be taken, Tavakoli submits, "as endorsement whatever the source of the original error," an endorsement of the suggestion that a strategy of running in front of the Black-Scholes steamroller applies to large investments -- a point for which there is "actually no empirical evidence."

It is a good point, and reinforces my suspicion that, pennies notwthstanding, there may be life in the old BSM steamroller yet. Enough life so that it is better to be in its driver's seat than to dart around in front of it.

P.S. Tavakoli has asked that I clarify two points in the above. First, she says, "I wrote that Taleb has 'corrected' the error [re: the phantom $20 billion], but he did so more than two months after his original posting, and only in the face of media pressure."

Taleb's more recent position is that the $20 billion figure stands for a "notional amount," and that the actual gains produced thereby were between $250 and $500 million. This is the subject of Tavakoli's second requested clarification. she questions "how Taleb made so little on bearish derivatives for the 2007-November 2008 timeframe in question...." The top of that range, $500 million, is only 2.5% of the $20 billion notional amount.